INTERNATIONAL TRADE: The case against floating exchange rates

Early in February, when I addressed the National Civic Council’s annual conference in Melbourne, a young, well-informed participant caught up with me during the coffee break.

He asked a number of questions, but, most notably, about floating exchange rates.

“You say that floating exchange rates disrupt the international trading system,” he said. “How do you answer the assertion that economic theory suggests that floating exchange rates are a stabilising influence?”

Juggling a cup of coffee, I gave him what, on reflection, was a less satisfactory response than his question deserved. My short answer was that we have had floating exchange rates and they have not stabilised the system.

The question deserves a more detailed answer.

The 1944 Bretton Woods agreement, concluded under the guidance of the United States and Britain at the end of World War II, gave the West 25 years of stability and unprecedented growth both in international trade and in domestic material prosperity. It also inaugurated the longest period of financial stability in history.

It was based on the idea of the US dollar as the basic international trading currency, underwritten by the US government, thereby making the dollar readily convertible to gold at a fixed price. If you like, it amounted to a de facto gold standard with a number of built-in stabilisers.

For example, countries within the system were required to keep their currencies more or less in fixed relationship, both with each other and with the US dollar.

Indeed, currency devaluations would be permitted only if countries encountered difficulties in meeting their international financial obligations, in which case they could devalue their currencies and restrict the flow of their imports temporarily until the situation was corrected.

Such measures could not be taken merely on the say-so of a country. Evidence of the problems had to be presented to both the International Monetary Fund (IMF) and the General Agreement on Tariffs and Trade (GATT). Only with the approval of the IMF and GATT could such corrective measures be taken.

From the point of view of theoretical economics this arrangement was riddled with holes, but it worked. Indeed, it created the longest period of economic prosperity and financial stability we have known.

The biggest criticism mounted against it was that, effectively, nations within the system surrendered control over monetary policy to the US. There were many who argued that control over management of interest and exchange rates should, properly, be in the hands of the nations themselves — or, better still, under the independent control of their respective central banks. That was precisely what happened once the US was no longer able to maintain the Bretton Woods system.

Countries regained control over monetary policy and mostly handed it to central banks. These agencies were charged with managing interest rates to contain goods (though not asset price) inflation. If inflation was deemed to be rising, then interest rates would be increased with the intention of slowing down monetary growth and reining in inflation. If growth was flagging, interest rates would be lowered, the expectation being that lower interest rates would encourage more investment and stimulate economic growth.

That certainly was the expectation of orthodox economists. They also believed that extremely low inflation delivered unalloyed benefits to an economy. Things did not always turn out as anticipated.

In Australia, for example, after 2000 inflation was being imported from abroad by virtue of our heavy dependence on imports. Increasing domestic interest rates was no answer: that merely slowed domestic growth without impacting on inflation.

Our central bank might set what is called the “official” rates of interest. “Official” might sound important, but that rate is nothing more than nominal. What borrowers pay to borrow money is decided by what the banks think they may or must charge.

As we now know, the Reserve Bank of Australia has almost no influence on real interest rates. Neither are borrowers in a position to tell whether or not they are being overcharged.

As a consequence of all this, individual countries are back to the position where they have no more control over monetary policy than in the post-Bretton Woods era when the US effectively set monetary policy. The difference is, we are all operating within an inherently unstable, free market financial system where the influence of excessive currency speculation, made possible by free floating exchange rates, determines the basis for the interest rates charged to customers by private banks.

When, in the 1970s, the Bretton Woods system collapsed (and here we need not concern ourselves with why), the political and economic consensus was moving increasingly away from market regulation towards deregulation and free markets — especially in the United States.

This should not be taken to suggest that free-market economists deliberately undermined Bretton Woods — they did not. But many of them were not unhappy to see the end of it. Especially this was true of the extreme free-market advocates in the US Republican Party.

They, and many others like them, convinced most of the West — in greater or lesser degree — of the supposed virtues of wholesale deregulation of financial flows and institutions, and, additionally, of the supposed overwhelming economic advantages of open domestic borders and free trade.

The belief was that floating exchange rates could satisfactorily replace the regulatory mechanisms of Bretton Woods.

Free-market enthusiasts devoutly believed that if world markets were opened up to the free movement of goods and capital, and if exchange rates were unpegged, the system would be automatically self-regulating.

The argument went something like this. As a country increased its exports, the resulting capital inflows would push up the value of the local currency. With a more valuable currency, overseas buyers would be less able to afford the country’s exports, and so its foreign earnings would decline and its overseas customers would look elsewhere for cheaper substitutes.

Automatic exchange-rate movements would thus regulate export flows. No country could secure and maintain a permanent export advantage. In this manner, international trade flows would be kept more or less in balance.

That’s the theory. So how can we explain why it went so badly wrong in the period since the great economic deregulation of the early 1980s?

What have come to be known as the saving nations — notably, Germany, Japan and China — have steadily increased their trading surpluses while other major trading nations — notably, but not only, the US — have gone steadily deeper into debt.

The reason is simple. There is not, and probably cannot be, an internationally enforceable agreement preventing countries from intervening to control the movement of their exchange rates. It has been suggested that those who do so must surely suffer adverse economic consequences, but the facts suggest otherwise.

In fact, maintaining a permanent surplus of export income over import expenditures has been shown to confer both economic benefit and political influence. This has been spectacularly demonstrated by China.

But there is more to it than that.

In the real world of business it is probably neither practicable nor possible to allow exchange-rate fluctuations to determine the year-on-year flow of exports. Take, for example, Germany.

Say Germany decides, as it once did, to make a huge capital investment in car manufacturing based on an estimated initial volume of sales to which was added a necessary growth in export sales year by year. In addition, it will have negotiated employment arrangements with unions and workers about wage levels and employment conditions. For these to be maintained, and for the capital investment to be serviced, the projected export volumes would have to be maintained.

In the days before Germany and other European Union countries adopted the euro as their common currency, it would have been extremely imprudent for the German government to allow exchange-rate movements of the Deutschmark to undermine the growth expectations of an important industry such as car manufacturing and, presumably, other industries.

So the German government, with as much subtlety as it could muster, contained exchange-rate movements of the Deutschmark to the degree necessary. So it was with Japan and China.

Why did the United States, for example, allow all this to happen to its disadvantage?

There were two reasons.

First, there was an ideological belief in deregulation and free market economics which the US believed it could persuade or compel other countries to follow. Interestingly, the British, in the old days when they were an empire, had a similar belief — and suffered the same fate at the hands of a developing United States.

Second, many US manufacturers believed that they could benefit from shifting their operations to cheap-labour countries offshore, especially if tariff barriers came down around the world so they could sell to the entire world. They followed this course, and at great cost to the US economy.

In the process, jobs and economic growth were exported to cheap-labour countries. The US in return got cheap Chinese imports, but surrendered the means of paying for them through exports. Its economy plunged into deficit and has been stuck there ever since.

The other adverse consequence for workers in the US was a permanent downward pressure on their wages and more job losses.

This, incidentally, did not help return the US to export competitiveness, but rather led impoverished US consumers to borrow money to maintain the spending levels to which they had grown accustomed during more prosperous times.

When all of this collapsed under the weight of debt in 2007-08, the resulting global financial crisis (GFC) almost brought down the world economy.

The imbalances in an imperfect system of floating exchange rates still plague the world economy.

It will require a change of attitude in the way we manage world trade — and indeed our domestic economies — before these wrongs can be righted.

Reviewing our commitment to the merits of floating exchange rates will not be sufficient to fix what is currently wrong with the way nations conduct their economic relations. But if a start can be made there, it might make other necessary changes possible.